Derivatives Don’t Kill People…People Kill People

Would you rather have more choices or fewer choices? I believe most rational people would prefer to have more choices in life rather than less. Now let me pose another question; would you rather have more or less derivatives? I can almost feel you cringe as you read that d-word.

Derivatives are just options; and options present choices. So if we like choices, and hence, options–then why don’t we feel the same way about derivatives?

Although the quote above comes from the Oracle of Omaha himself, many people don’t realize that Warren Buffett has made (and continues to make) a fortune by understanding and using mispriced derivative contracts. In this post, I’ll try to explain the risks and rewards of derivatives–including an actual example of how we earned triple digit annualized returns 1 using an options contract, a simple type of derivative.

Think of derivatives as you would think of any “weapon”. They can be deadly in the wrong hands but they can also be vital in terms of protecting the people and things that we love. In other words, “guns don’t kill people; people kill people.”

“We have entered into various types of derivatives contracts…Why, you may wonder, are we fooling around with such potentially toxic material?…The answer is that derivatives, just like stocks and bonds, are sometimes wildly mispriced.”

~ Warren Buffett

As a hedge fund manager, I have a fiduciary obligation to protect and grow capital for my partners. As such, I use derivatives to manage risk as well as to make money. But derivatives are not for the faint of heart. Unlike most forms of investing, derivative markets are known as a zero-sum game. In stock and bond markets, this is not true; as the economy and the businesses within the markets grow, the pie of profits grows along with it. But derivatives don’t represent ownership in a business like a common stock. Derivatives “derive” their value from an underlying asset; like a stock. Because derivative markets are zero-sum (pie is fixed and doesn’t grow) for you to win a dollar of profit, someone else has to lose that same dollar, but that is not always a bad thing2.

There are plenty of win-win transactions in the derivatives market, which explains why that market has grown tremendously. However, there are other reasons for this growth which are less palatable. Wall Street firms have been pushing derivative products as a way to spread and reduce risk. But, in actuality, they are increasing and concentrating that risk in fewer and fewer firms3.

One reason this problem has been unnoticed by many in the media and the investment community is because of the way Wall Street calculates risk. Wall Street ignores gross exposure and only looks at net exposure. This methodology is not only misleading and faulty, it is EXTREMELY dangerous4. The article below gives more details for those that are interested.

The good news is that by understanding derivatives–whether they are as simple as options (Calls & Puts), or as complex as Credit Default Swaps (CDS); one can make a fortune5. Here is a very recent example using a hometown company: Darden Restaurants (DRI), one of the world’s largest restaurant companies with a market cap over $8 billion. You might recognize some of their brands.

Recently, a very prominent activist hedge fund, Starboard Value, took a significant stake in DRI and presented a very detailed turnaround plan for the lackluster company. Watch this short but hilarious clip from John Oliver’s Last Week Tonight to understand just how bad Darden’s management was performing:

After going through the presentation and conducting our own due diligence, I felt very bullish on DRI. But instead of just buying the common stock, I was able to find an attractive opportunity in the options market; specifically the long dated call options. Long dated options are the most likely to be mispriced. For a quick primer on the Basics of Options Trading, check out this infographic made by Visual Capitalists:

This ‘mispricing’ is due to the equation that most investors use for options; the Black-Scholes model; named after the Nobel Prize winning professors6. Mathematically, the model is elegant, masterful, even beautiful. But in the real world of capital markets, the equation below is full of not beauty, but bullshit…A slight change in any of the many variables (inputs) can have a significant impact on the resulting price (output). One of the most important variables in the model is time. The longer the time horizon, the greater the risk of the model being wrong. And that’s where we come in…

We were able to make an extremely attractive return on our investment in a relatively short amount of time. Please do keep in mind, that is NOT usually the goal7.

Here’s how we did it: In mid October of last year, Darden’s stock price was around $48. But the option to buy the stock for $40 anytime before January 2017 was selling at just $10.70. Because I felt the option was mispriced (and because we’re nimble and can move faster than the bigger firms on Wall Street), I bought those call options. I believed that as Starboard implemented their turnaround plan, the investment community would recognize it eventually and bid up the stock price. I liked the stock, but I loved the options as they gave me leverage without recourse. Fortunately, it didn’t take as long as expected for others to see the value we saw and the stock began to rise. The increase in the stock price naturally made our CALL options more valuable, pushing up the price of our options. But our options rose much faster than the stock, as you can clearly see from the chart below showing performance from October 10th, 2014 to January 29th, 2015; which is when I closed our position and took profits8.

The green line above represents the price of our options while the white line represents the price of Darden stock. The options magnified the gains of the stock allowing us to earn a rate of return of over 74% in that time, which equals over 360% annualized9. Now, this doesn’t happen all the time so it’s important to keep your expectations realistic. Things could have gone against us and if they had, we could have lost money. That’s why the most important part of investing is to make sure you understand your investment thesis—don’t just gamble. Remember, rule #1 is don’t lose money!

So although derivatives can be dangerous in the wrong hands, what really harms investors is a lack of understanding and/or due diligence. In the right hands, derivatives can be magical.

1> 360% RoR Annualized; results not typical

2 Sometimes options are used as insurance so $1 lost may be protecting more than $10

4 Net exposure ignores counterparty risk, which is a very real risk and must be accounted for

5 Losing a fortune can also happen so don’t try this at home

7 We have a 3-5 year time horizon on our strategies

8 Positions can be closed for reasons other than a change of investment thesis

9 Versus approx. 28% for the common stock

Written By: Vijay Marolia

DISCLOSURE: THIS IS NOT A SOLICITATION TO INVEST. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.